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If I am not mistaken, the federal funds rate is the rate at which commercial banks, money market funds and market makers pay for overnight US Treasuries. In theory, it should be equal to the IOR rate, the rate which the Fed pays on reserves because commercial banks who have access to the IOR rate are able to arbitrage away the difference. However, in practice, this does not take place. A previous Stack Exchange answers attributes this to the stigma attached to borrowing from the Fed discount window however, as the primary rate is now IOR, I don't understand why commercial banks still fail to arbitrage the difference in the FFR and IOR.

In fact, looking at Fred shows that the federal funds rate now lies consistently lies somewhere between the IOR rate and the ON RRP rate, often to the point of 15 basis points.

Is it a matter of regulations? Is it a matter of banks not wishing to arbitrage due to the minimal return involved?

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  • $\begingroup$ "If I am not mistaken, the federal funds rate is the rate at which commercial banks, money market funds and market makers pay for overnight US Treasuries." The federal funds rate is the rate for the purchase and sale (borrowing and lending) in the overnight federal funds market. During Quantitative Easing the Fed purchases securities from banks, which increase federal funds, and from non-banks, which increase fed funds (bank reserves) and bank deposits. To keep banks from competing with non-banks for short term Treasuries the Fed pays interest on excess reserves above the Treasury bill rates. $\endgroup$
    – SystemTheory
    Nov 2, 2021 at 14:59
  • $\begingroup$ Think of the overnight federal funds rate as an overdraft service for banks, who need to borrow bank reserves in the federal funds market, and where the Fed is the lender of last resort. In other words the Fed provides the ultimate bank overdraft and this gives Fed control of the interest rate in the Fed funds markets. But borrowing from Fed is most expensive so banks do repurchase agreements which may require a pledge of Treasury securities and/or other govt Agency debt. This is where Treasuries, used as collateral in the wholesale money markets, impacts how the Fed sets IOER rate under QE. $\endgroup$
    – SystemTheory
    Nov 2, 2021 at 15:06
  • $\begingroup$ A quote... "If I am not mistaken, the federal funds rate is the rate at which commercial banks, money market funds and market makers pay for overnight US Treasuries." I think there is no Treasury bond directly involved in the agreement between the private parties' loan interest rates that go into calculating the effective FFR. A quote from FRED... "The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target." The OMOs can involve Treasury bonds. $\endgroup$
    – H2ONaCl
    Nov 2, 2021 at 21:56

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There are some important market players who have cash to invest but do not have access to the IOER. For example , the Federal Agencies (Freddie Mac, Fannie Mae) cannot utilize IOER because it is only available to deposit taking institutions. So they put their cash in FedFunds, driving the rate down. At some point it becomes worth it for a deposit taking institution to borrow that money and reinvest it in IOER. This transaction has costs such as balance sheet usage so it requires a margin. That can explain why Fed Funds trade slightly lower than IOER.

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